So what will happen? In the end, I’d argue, what must happen is an effective default on a significant part of debt, one way or another. The default could be implicit, via a period of moderate inflation that reduces the real burden of debt; that’s how World War II cured the depression. Or, if not, we could see a gradual, painful process of individual defaults and bankruptcies, which ends up reducing overall debt.
Needless to say, Krugman approves of the moderate inflation/WWII approach, rather than the painful process of actual defaults and bankruptcies.
And though Krugman has slammed Bernanke in the past, it seems that the Fed Governor is coming around to the same realization — hence the latest FOMC’s declaration that it will aggressively pursue a higher level inflation that we’ve seen, a rare statement from any central banker.
Either way — if our only choices are between implicit default and painful default — it’s hard to get too excited about anything in the US economy right now.